Month: June 2016

The polls pointed to a close run thing in terms of the Brexit vote, albeit with Remain pulling marginally ahead , but the markets had convinced themselves that the probability of a Leave vote was virtually zero. Behavioural economists talk of Narrative Fallacy and Confirmation bias ( we convince ourselves that our interpretation of events is true and ignore any conflicting evidence) and those concepts seem to capture what developed in the FX and equity markets in the days before the referendum. Consequently, the subsequent carnage in markets can in part be explained by traders and investors scrambling to exit positions that had gone horribly wrong.

Any short term bounce from oversold readings may be short lived, however, as it seems fairly clear that the uncertainty of Brexit alone will hit economic activity, not just in the UK but across Europe and beyond; consumers are likely to become more cautious, resulting in higher saving and reduced spending, with firms postponing or even abandoning investment plans. The plunge in equities has hit household wealth and house prices are also likely to be adversely affected. Bond yields have fallen again and we may well see lower short term rates as well, so further reducing the income of savers and putting an additional squeeze on bank margins.

Any change in UK activity impacts Ireland ( some studies suggest a 1% reduction in UK GDP reduces Irish GDP by 0.25%) and the export sector would obviously also be impacted by weaker euro zone growth. Domestic demand in Ireland may also take a hit, as consumers and firms react to the uncertainty caused by this seismic event. Short term FX moves may not have a huge impact but it appears likely that sterling may be marked down for a long period, so putting margin pressures on Irish SME’s trading with the UK.That uncertainty may well last some time, even if market volatility settles down; it is up to the UK to trigger Article 50 and the exit negotiations, with the latter taking two years at least, so this is not a short-term event.

On the positive side some argue that Brexit is an opportunity for this country, in that firms may leave London and other parts of the UK and move to EU States in order to secure access to the single market. Financial services, in particular, is seen as ripe for such a migration.

That belief ignores the reality of the current economic situation in Ireland; there are huge capacity constraints in a host of areas, including housing, commercial property, education, hospitals and infrastructure, particularly in and around the Capital. Consequently it is hard to see how Dublin could absorb a swathe of large financial institutions locating here- residential rents are already at record highs, for example, so the influx of highly paid financial professionals is likely to put further pressure on accommodation in Dublin.

Over time, capacity can be increased, of course, but Public capital spending under the Government’s latest plan is set to rise to only 2.7% of GDP by 2021, which is very low by EU standards and woefully inadequate given years of spending cuts. Ireland can therefore not absorb large numbers of firms even if they did wish to relocate here and if one adds the other short term negatives discussed above it is hard to make the case that Brexit is good for Ireland in any economic sense.

As pointed out in a recent Blog (‘Next Government may have €2.5bn more to play with’) the European Commission has revised up its estimate of Ireland’s longer term potential growth rate and as a result the Government has more fiscal room to manoeuvre than previously envisaged. The ‘Summer Economic Statement’ projects spending and taxation figures out to 2021, based on these new assumptions, and as such helps to clarify and quantify some of the budgetary options open to the Administration, although begging other questions about the effective Fiscal Space available.

For 2016, tax and PRSI revenue is now expected to be €1bn ahead of target, with about half of that earmarked for higher spending, largely on health. Consequently , the fiscal deficit is now projected at 0.9% of GDP instead of 1.1%.

A lot of media coverage has focused on the outlook for the 2017 Budget. That is predicated on 4.2% GDP growth following 5% this year, which feeds into revenue projections, and under the Expenditure benchmark the Government could increase spending (net of any tax changes) by up to €1.7bn, or 2.5%, and thereby keep the structural budget deficit on a downward path. Of course the option is always there to increase spending by less than the stated sum, which would reduce the deficit and therefore the national debt at a faster pace, which some would argue for, given that the economy is operating above capacity.

The €1.7bn fiscal space is likely to be used, nonetheless, and Finance estimate that demographic pressures and existing public sector pay commitments will swallow up an additional €0.7bn, leaving a net €1bn for the Minister to utilize. The Statement indicates that two-thirds of this will go on increased current spending, with the balance used to fund tax reductions, a split set to continue out to 2021.

On the published figures the gross fiscal space over the next five years is projected at €14bn, with a net figure of €11bn. However, the €3bn gap makes no allowance for any general rise in public sector pay or the indexation of the tax system and may also substantially underestimate the demographic pressures on areas such as education and health, particularly the latter if the recent past is anything to go by. As a result gross voted current spending actually falls substantially relative to GDP ( to under 20%) which appears unrealistic and inconsistent with a pledge to devote far more resources to the provision of public services.

Public Capital spending has plummeted in recent years and the Statement makes great play with the need to significantly increase resources devoted to infrastructure and housing. Yet, by 2021, gross capital spending is still only 2.7% of GDP, against 2.1% this year. In fairness, the EU’s fiscal rules are a constraint in that capital spending in the aggregate is not excluded from the Expenditure benchmark, but it is clear that public sector investment will still be taking a very low share of GDP by international standards ,and the planned increases are certainly not transformative.

Economics is about choice and this Statement highlights that while the new Government may have a little more flexibility than thought it will still be faced with difficult decisions as to how to allocate the fiscal space between taxation and spending, and indeed how much is used to expand the volume of public services and how much in higher pay for those delivering the services.

The Irish recession was long and extremely steep but it ended over six years ago and the economy is now growing rapidly; real GDP has risen by 25% from the cycle low and is now over 10% above the previous peak. Indeed, according to the Department of Finance, Ireland is now operating above full capacity. Others, including the ESRI and the Irish Fiscal Advisory Council have queried this but all agree that the degree of spare capacity in the aggregate has diminished. It is also true that one does not have to look hard to observe capacity issues in specific sectors of the economy, particularly in and around the capital.

Take tourism, which is booming; last year the number of visitors to Ireland exceeded 8.6mn, having grown by 13.7%, and on the evidence of the first quarter the figure for 2016 will exceed 9.5mn. That has put pressure on accommodation, and the price of a hotel room rose by over 5% in May alone and is 9% up on the previous year. One could not give a hotel away not so long ago but now rooms are scarce and are 22% more expensive than in 2012. Housing in general is also scarce , of course, particularly in Dublin. Rents, nationally, are at record highs and on the CSO data there is no evidence of any significant change in trend, with the latest figure for May showing a 9.7% annual rise.

Irish residents are taking more foreign trips too ( up an annual 13% in the first quarter of 2016) and it is not surprising that Dublin Airport is now seeing record passenger numbers, with 2.5mn in May alone , an 11% rise on the previous year, implying the 2016 figure will be well in excess of last year’s 25 million. The Airport is building a new runway to help cater for the increased demand, and it is instructive that the planning permission was initially granted in 2007 and then put on hold.

Car ownership is also growing strongly again, with sales up 31% last year following a 29% increase in 2014. The latest data for this year points to a 25% rise which would take the annual figure to over 150k for the first time since 2007. Hardly surprising then that record numbers are using the M50, with gridlock at peak times not uncommon.

The growth in the population as a whole is also putting pressure on schools and hospitals, although one could be forgiven for thinking the population is falling given some media coverage of emigration. The reality is that the population surged by over half a million in the six years to 2009, reaching 4.53mn, and by 2015 had risen to 4.64mn, as net migration has slowed to virtually zero and is anyway offset by the natural increase.

The conclusion has to be that Ireland needs to embark on a huge programme of capital investment in order to tackle capacity issues, particularly in and around Dublin. Borrowing costs for both corporates and Governments are at historically low levels and there has been some increase in building, both residential and commercial, although the former is still well below the annual demand, so exacerbating the existing supply/demand imbalance. Unfortunately it is a mark of the absurdity of the current fiscal rules imposed on euro members that capital spending by the State is not excluded from the expenditure constraint ( only some incremental spending is allowed) and so any amelioration in these capacity issues is unlikely to occur any time soon.

The latest Exchequer figures show that Irish tax receipts are again well ahead of profile, raising the prospect of a much smaller fiscal deficit in 2016 than planned and tempting the new Government to spend some of the largesse before year end. That was the case last year but this time is different and any tax bounty may have to be used to reduce debt rather than to increase expenditure, although of course economic shocks such as Brexit may mean that bounty is smaller than now appears.

The 2016 Budget projected tax revenue of €47.2bn for the year, implying a 3.6% rise on the 2015 outturn. That appeared a modest target and at end-May receipts were running 8.9% up on the previous year and €770mn or 4.3% ahead of the monthly profile. That aggregate overshoot is very similar to the pattern in 2015, with corporation tax again the main factor, although this time excise duty is also extremely buoyant, with income tax on target and VAT running below expectations.

By the autumn of last year the tax overshoot had accelerated to almost 6% and the Government announced supplementary estimates, intending to spend a fair proportion of the windfall. In the event they did not manage to spend as much as indicated although voted expenditure still ended the year some €1.3bn above the original target.Tax revenue continued to exceed expectations, emerging 7.8% above profile, or a massive €3.3bn.

At that time the only EU fiscal constraint on Ireland was to get the deficit below 3% of GDP, which was duly achieved even with the additional spending ( the final figure was 2.3%). In 2016 there are two constraints, however, with neither relating to the headline deficit. The first is the expenditure benchmark, which sets a limit on permitted expenditure in the year. The second is that the fiscal deficit, when adjusted for the economic cycle, must fall by at least 0.5% of GDP. Regular readers of this Blog will be familiar with the problems associated with determining Ireland’s potential growth rate, and hence estimating the cyclically adjusted fiscal position. As it currently stands the Irish Government believes that the structural deficit is set to decline by 0.4% while the European Commission argues that the reduction is only 0.1% and has stated that ‘ further measures will be needed to ensure compliance in 2016′. The Irish Government will argue the case and other countries have been given leeway so the outcome is uncertain, but it may well be that the current tax buoyancy will not result in much or any additional unplanned spending this year.